Stay the course

The Reserve Bank of India (RBI) will announce its mid-year economic outlook and its monetary and credit policy at noon today. The announcement will be made against the backdrop of the most turbulent macro-economic environment the country has seen in a long time. Inflation, even though it has been coming down steadily from its high of nearly 8.5 per cent, still hovers above the 7 per cent mark.

The various attempts that the government has made, by way of customs and excise duty cuts on petroleum and other products, haven't had much impact and, in any case, are essentially one-off instruments.

The RBI is perceived as the main inflation-fighter and everybody is waiting to see what, if anything, it does to rein in inflationary pressures.

Though many people expect the RBI to raise interest rates, there is a strong argument to be made for not doing so. As the Governor, Dr Reddy, has said, the primary cause of inflation is the spikes in the prices of oil and other commodities over the last several months.

Not since the Gulf war of 1990-91 have oil prices been so high in real (ie inflation-adjusted) terms. On that occasion the spike did not last for very long; this time round, there are indications that the current levels will persist for a while.

This is the major driver of inflation, in a classic "supply shock" scenario. There is virtually nothing that monetary policy can do to offset it; the only way it can work is to slow down growth to a level that dampens inflationary pressures even in the face of high energy prices.

Indian industry has been doing quite well over the last two years. A major contributor to its recovery has been the soft interest rate regime.

The sectors that have led the recovery are typically those whose performance is relatively sensitive to interest rates. Earlier it was construction-related activity and transportation equipment; of late the leading role is being played by the machinery and equipment sector.

If the RBI were to raise interest rates now, it could well cause a setback to the growth momentum being generated by these sectors, without immediately impacting on the inflation rate.

Given that inflation is, in any case, beyond its control, the RBI has everything to lose and nothing to gain by monetary tightening. Its best option, as strange as it may sound, is to do nothing as far as interest rates are concerned.

There is, of course, enormous pressure on the RBI to do something. The main argument in favour of tightening is that inflationary expectations are gathering momentum and the RBI can moderate them through a mild increase in interest rates.

Of course, nobody can say where oil prices can go, so even this may prove to be a short-lived measure. But, if it does accept this argument, the only thing the RBI can do is nudge rates upwards as gently as possible, keeping its eye on the momentum in industry as it does so.